Jeremy Warner: More banks is what we chiefly need

Outlook: Dear old Alan Greenspan. Ever since the banking crisis first broke, the former chairman of the US Federal Reserve has been furiously scribbling away in an attempt to defend his legacy from the growing weight of lacerating commentary which blames Greenspan himself for allowing financial markets to run amok and the boom to get out of control.

He's been at it again this week. His arguments are now familiar enough. Number one is that Mr Greenspan's faith in markets was based on a false premise – that enlightened self-interest alone would ensure that owners and managers of financial institutions would not take such extreme risks with their capital that they endangered the whole system. That assumption turned out to be wrong.

Number two is that though it is certainly possible for monetary policy to defuse asset bubbles of the type that led to the credit crunch, it can only be done at the expense of crushing economic activity. No central banker would willingly take such action. Number three is that though it may be easy enough to identify an asset bubble in the making, determining when the euphoria of a bubble turns into the fear of a bust is virtually impossible.

All these are no doubt valid points which contain lessons for the future. But they would have a lot more credibility were it not for the fact that, as chairman of the Fed, Mr Greenspan had responsibility for banking supervision as well as monetary policy.

The Bank of England's failure to foresee and prevent the credit crunch can be blamed partly on the fact that when the Bank was given independence in 1997, it was stripped of responsibility for banking supervision. The Fed, which had responsibility for oversight and yet still failed to see the credit crunch coming, has no such excuse.

In the lead-up to the G20 meeting, much twaddle has been said and debated about how to reform and reboot the regulation of banks and financial markets so that they cannot do this to us again.

It's hard to disagree with much of it, but it's equally hard to see it doing much good. Banks are so chastened by the experience of the last two years that for the time being they don't need regulating at all to prevent them from misbehaving. Banking has always been extraordinarily highly regulated, yet somehow or other the box-ticking teenagers of banking supervision always manage to miss the big picture. Like a swollen river, an excess of capital will invariably find its way around any obstacle that is put in front of it.

Failures in regulation are nearly always qualitative, rather than quantitative. It doesn't matter what capital controls, checks and balances, stress-testing, rules, regulations and accounting standards are put in place, unless there is some wise old bird sitting there at the top with a long enough memory to know the causes and consequences of the last banking crisis, and the force of will and independence of mind to defy the politicians, there's always eventually going to be another bust.

The bizarre thing about Mr Greenspan is that on the face of it, he was indeed old and wise enough to play that role, yet he too allowed himself to get sucked into the euphoria of the bubble, and worse, started to believe – as all policymakers do if they are in the job long enough – that the apparent success of the economy was all down to him.

Mr Greenspan forgot the golden rule of central banking, invented by one of his forebears, that you must always remove the punch bowl just as the party gets going. He did the opposite, thereby encouraging the view that whenever the economy or financial system stalled, the Fed would come riding to the rescue.

This was not the only form of moral hazard that policymakers were instrumental in creating. They also encouraged the development and formation of "mega-banks", in the mistaken belief that such organisations would be too big to fail and therefore would be easier to regulate. The reverse turned out to be true. Not only did they fail, but, because they had become too systemically important, the taxpayer has been forced to prop them up.

Encouraging more competition in banking ought to be one of the first priorities of regulatory reform. A larger number of smaller banks may be more difficult to keep any eye on, but failures are also far less likely to be systemically significant and would therefore encourage the rediscovery of such good, old-fashioned financial virtues as caveat emptor. Predictably, this common-sense idea doesn't seem to form any part of the G20's current reform agenda. Rather, it is all about the doomed endeavour of how better to regulate the mega-banks.